Monday, February 27, 2012

Are Markets in Denial?

The first quarter of 2012 is off to a heady start for equities, with the S&P up 24% from its October 2011 lows. Dow laggards like Bank of America are up in excess of 40% over this period. The Dow now at our about 13,000, is at levels last seen at its peak in the 4th quarter of 2007.

At the same time, US Treasury Bond prices also continue to test all time highs, with the 30-year yield down to 3.05% and the 10-year yield once again falling below 2%. High yield bonds (once known as junk bonds is a less optimistic era) are at similarly lofty levels with many sub-investment grade companies raising capital in the 6.00% range.

Intuitively, of course, none of this makes sense. In the latter part of 2007 when the Dow first crossed 13,000, we saw a GDP print at just under 5%, versus the 1.8% in the 4th quarter of 2011. Unemployment stood at 4.6% versus the 8.3% today and residential housing prices were some 30-40% higher than where they now stand. Perhaps more to the point of this article by June 2007, the 10-year US treasury bond stood at 5.2% (versus 1.91% today).

So what's driving these appreciated valuations in both equity and debt markets that, historically, perform inversely? Bond market yields fall (and prices rise) when the economy is forecasting dark days ahead, with muted growth and low inflation, and this would appear to be what bonds are now signalling. At the same time, the stock market has put the risk of further recession firmly in the rear view mirror, plowing ahead to new highs.

So, what's up? Liquidity and lots of it. As we're all aware, the world is awash in cheap money as central banks in the US and around the world continue to print new money at unprecedented levels. Financial assets are posting new highs, but if cheap money is propelling all asset classes, why hasn't housing recovered?

We think the reason for this anomaly lies in the velocity of money and the banks' role in expanding credit. Of the markets listed above (stocks, government bonds and junk bonds) none of these markets rely upon credit expansion to drive prices higher (although returns are often leveraged with debt). Housing, is a very different story, where the home mortgage and the buyer's willingness to take on debt have long been a staple of this market. With mortgage credit constrained (due to higher lending standards) and individuals either not qualifying for or apprehensive about taking on a mortgage, housing languishes in the doldrums.

So what do we know? We know that equity and bond prices continue to push new highs, while home prices skirt along the bottom. And we know that the underlying economic data for GDP growth and employment are now far less robust than they were when we last visited these levels in equities and bonds. Thus, we can only conclude that the values reflect the excess liquidity finding a home in financial assets rather than a fundamental analysis of the prospects for growth in the economy. If we are correct, then the markets for credit and risk, both equities and junk bonds, may be in denial and headed for a major correction.